Burton Malkiel’s brilliant book A Random Walk Down Wall Street has, over the years, convinced legions of investors the wisdom of settling for average returns by investing passively through broad-market index funds. So, it is with some sadness that one notes that Prof. Malkiel, who is also the chief investment officer of the China-focused indexing firm AlphaShares (Claymore Investments’ China ETF (TSX: CHI) owns the Guggenheim China All-Cap ETF (YAO), which tracks the AlphaShares China All-Cap Index) , is now recommending — surprise! surprise! — investors add more China to their portfolios. In a recent interview with IndexUniverse.com, Prof. Malkiel maintains that he prefers broad-markets index funds:

Well, you probably know me as someone who loves the broadest-possible ETFs. I don’t believe that people can time and I don’t believe that people can get into exactly the right sectors.

So far, so good. It’s the Prof. Malkiel we knew or thought we did. But now, he has modified his tune a little bit. In response to a question on whether investors who don’t like the way China is weighted in an index such as the Vanguard Total World Stock Market ETF (VT) should augment it with a China-specific ETF, the good Professor answers in the affirmative:

Yes, exactly. That’s how I’d use the specific ones. I don’t say pick China because China is going to do better than the U.S. over the next six months. I have no idea. I’m still a “random walker.” But I do think a broad portfolio needs more China.

But why stop with China. Smartphones are pretty hot these days. Why not add the First Trust NASDAQ CEA Smartphone ETF (FONE)? (I’m not making this up. I Googled for a smartphone ETF on a lark and it turns out such a beast exists already.) Or any other sector that is experiencing tremendous growth for that matter?

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I don’t think Malkiel’s advice is contradictory. In the interview, he says that VT (Vanguard Total Stock Market) does not have enough China. This is true if you look at relative percentages of world GDP. China is roughly 11%-15% of world GDP depending on whose numbers you use, yet it has less than 5% weighting in VT. In fact, almost all world indexes seem to underweight China, probably because of a cap-weight bias. (It doesn’t help that a lot of large Chinese companies have a relatively small float.) People also think that by buying an “EAFE” fund they’ll get a reasonable amount of China, but it usually isn’t the case.

I think it’s probably accurate that most people could use a higher relative China weighting if their goal is to replicate the performance of the world economy. Just as an example, the Sleepy portfolio is 20-26% Canada for instance, when we’re roughly 8% of world GDP. The Sleepy portfolio is 10-15% emerging markets, of which the China weighting therein is about 17.5%.

It seems that there are very few indexers who can resist the temptation to make side bets. We’re wired to have opinions about investments even when strong evidence says that acting on our opinions will likely lose us money.

@Viscount: It’s important to note that traditional indexes are weighted according to the size of a country’s stock market, not the size of its GDP. Emerging countries may have largest economies, but they don’t necessarily have large (or well developed) stock markets, so it is appropriate to weight them accordingly in a global portfolio.

It is usually appropriate to overweight one’s own country in a portfolio for reasons of cost, tax-efficiency and currency risk — although most people go overboard. But Malkiel’s advice on China is indeed contradictory to a passive strategy. Funny how one’s opinions can change once they start a fund company.

@CCP: But that’s just it — weighting by the size of the stock market (i.e. size of the stock market capitalization) is a form of cap-weight bias. It’s logically inconsistent for some investors to push Fama-French-style indexing (i.e. with small cap and value tilts) while critiquing other investors who are looking to apply that same tilt geographically, in a manner that is not inconsistent with world GDP.

@Viscount: You could make an argument that country allocations should be made according to economic footprint. The problem here is that we are then making an active bet because if I overweight China, for instance, some else is under weighting it for what they believe is a very good reason. That’s fine but I can’t claim to be passive and make active country bets at the same time.

My question is why stop with China? If Malkiel’s argument is correct, we should all be weighting emerging markets at close to 40% of our equities because that’s their share of global GDP if we use market exchange rates. Since many of these countries manage their currency rates, at PPP terms, emerging markets should make up more than 50% of one’s portfolio. Or what about some European countries? IIRC, allocation to Germany is much smaller than UK in EAFE but its economy is 50% larger.

@Mike: The book does contain tips on active investing. However, it is more along the lines of, “if you must be active, here are some tips but I still think passive is the way to go”…

@Michael: It is tough enough resisting making side bets. It’s tougher when passive investing advocates are recommending us to do it!

@Raman: I guess what bothers me is that Prof. Malkiel is sounding like a salesman and recommending over weighting products he sells.

@Canadian Couch Potato: Even here in Canada a large proportion of economic activity is private and not represented in the stock market. Should we then dissect the Canadian economy into sectors and weigh them based on their economic footprint?

@Viscount: Fair point But one, that we can accuse Prof. Malkiel to be guilty of as well. Prof. Malkiel was a strong critic of fundamental indices because of their value tilt. He argued, rightly, I thought, that it is a form of active management.

“We are impressed by the inexorable tendency for reversion to the mean in security returns. Consider the chart showing the difference between mutual funds with a “value” mandate and those with a “growth” mandate. Since the late 1960s, “value” funds have generally outperformed growth funds. But since 1977 — indeed since 1937 — there is little to choose between the two. Indeed, for the first 30 years, growth funds rather consistently trumped value funds. Never think you know more than the markets. Nobody does.”

Arguing for weighting based on a country’s share of global GDP is incorrect for two reasons. First, GDP includes economic activity by companies not based in China. A more correct measure would be the GNP, which excludes economic activity by foreign companies but does include economic activity by domestic companies in foreign markets. However, a more fundamental problem is that you cannot invest in all of a country’s economic activity by investing in its stock market. You miss out on economic activity by governments and private companies that way. I’d argue that in a economy like China’s, where there is a lot of state intervention in the economy and even outright ownership of companies by the state, this is a significant problem for those arguing for GDP weighting.

@Viscount: Overweighting a country because you like its economic prospects is not the same as tilting a portfolio based on Fama-French principles. Small-cap and value stocks have higher expected returns because they carry more risk. It’s simply an asset allocation decision: how much risk are you willing to accept in the pursuit of higher returns?

I suppose you could argue that emerging markets also have a higher expected returns than developed markets, and therefore also have higher expected returns to compensate. That would be fair enough. But that does not seem to be what Malkiel is arguing. He’s talking about how valuations are low, and their economy is growing faster than the US, etc. That’s an active bet, not an asset allocation decision.

@CCP: You’re misunderstanding my point. The reason China is underweighted in most indexes is because there are effectively no large caps in China.

As one tilts one’s allocation towards smaller cap stocks, one *should* pick up more China, and vice-versa. It has nothing to do with active bets about the future of China relative to the rest of the world (though in reality Fama-French is an active bet in itself, just as overweighting Canada is a form of active betting).

@Viscount: To say that following Fama-French principles is an active bet makes no more sense than saying it as an active bet to invest in stocks rather than bonds.

Re: “Weighting by the size of the stock market (i.e. size of the stock market capitalization) is a form of cap-weight bias… The reason China is underweighted in most indexes is because there are effectively no large caps in China.” I cannot argue with these tautological statements.

Viscount’s comments address a key point. Strictly speaking, the “market” is every asset on the planet, traded and non-traded, public and private. Theoretically, that’s what an investor should own. But the practical world interferes with what is actually available to be bought and is visible with a believable price attached. The use of such market-representing indices as the S&P 500 originally, and now expanded to the world with other indices, based on stock market prices has to do with the convenience and availablility of data. It was the best-available reasonable proxy for the intrinsic value of assets and of the market at the time financial research began. No longer necessarily so. That the S&P 500 itself makes judgments as to what properly represents the US economy, including or excluding some companies on factors other than market cap (and other adjustments like public float), should tell passive purists that market cap is not a final definitive practical answer. The expanding availability of treatable economic/financial data introduces the possibility of alternative weighting schemes and associated investment funds to better represent the market portfolio. The existence of net risk-adjusted superior returns, from such as small caps and value stocks, also suggests market cap weighted market proxies do not necessarily provide the best answer, either as market benchmarks or as practical investment strategies.